A Tax Term Every Startup Should Know

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For most startup owners and employees, being able to cite sections of the internal revenue code is probably not what you signed up for. But, there should be one notable exception: the 83b election.

Many startups use stock as a means of compensation for their early employees. More specifically, they use what is called restricted stock, meaning if the employee were to leave before the stock "vests" the employee would forfeit the stock. When the stock vests is when it becomes taxable to the employee (yes, stock vesting is taxable and goes directly on the employee’s W2) and the amount of income depends on the value of the stock, which of course is dependent on the value of the company.

So, let’s say you have given an employee 400 shares of restricted stock that vest on the first day of the next four years. If the value of the shares in each of those years is $1, $2, $3 and $4 -- the employee would have $100, $200, $300 and $400 of taxable income during the next 4 years. Assuming a tax rate of 35 percent the total tax would be $350.

What an 83b election does is accelerates all of the vesting to day one of the restricted stock grant and you would pay tax on the year one value. So in our example above, if an 83b election is made the employee would have $400 (all 400 shares times $1 per share) of income in year one and pay tax of $140 (using our same 35 percent tax rate). Thereafter, when the other shares vest there is no taxable event.

So why do you care as a business owner? Two reasons: first, remember the company owes matching Social Security and Medicare taxes (7.65 percent) on this income. So in our above examples, having an employee made an 83b election would save the company approximately $16 in tax over the four years. Second, if you were to get venture capital funding, there would undoubtedly be a provision where your shares would be restricted and earned back so you do not run off with the money. In this case, the owners would be personally affected by an 83b election.

83b elections must be made within 30 days of the grant, so time is an issue here.

John Stanfield is the managing principal of Stanfield & Associates LLC. He is a tax and financial expert that can provide valuable and helpful tax tips and tax advice for both individuals and small business owners. John holds a Masters Degree in Accountancy from DePaul University and is a licensed Certified Public Accountant in Illinois. He is also a member of the American Institute of Certified Public Accountants and the Illinois State CPA Society. Follow @StanfieldCPA on Twitter and join the conversation at facebook.com/StanfieldCPA.